chapter 8

PowerPoint Slides prepared by: Andreea CHIRITESCU

Eastern Illinois University

PowerPoint Slides prepared by: Andreea CHIRITESCU

Eastern Illinois University

How Firms Make Decisions: Profit Maximization

CHAPTER

1© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Goal of Profit Maximization• The firm

– A single economic decision maker– Goal: to maximize its owners’ profit– Decisions

• What price to charge• How much to produce


Understanding Profit• Accounting profit

– Total revenue minus accounting costs• Economic profit

– Total revenue minus all costs of production, explicit and implicit

• Profit– Payment for two contributions of

entrepreneurs: risk taking and innovation


Understanding Profit


Understanding Profit• Economic profit

– Proper measure of profit: for understanding and predicting the behavior of firms

– Recognizes all the opportunity costs of production• Explicit costs and implicit costs


The Firm’s Constraints• Demand curve facing the firm

– Tells us, for different prices• The quantity of output that customers will

purchase from a particular firm

– Shows us the maximum price the firm can charge to sell any given amount of output

– One firm; All buyers (potential customers)


Figure

The table presents information about Ned’s Beds.

The Demand Curve Facing the Firm


1

Figure

The table presents information about Ned’s Beds. Data from the first two columns are plotted in the figure to show the demand curve facing the firm. At any point along that demand curve, the product of price and quantity equals total revenue, which is given in the third column of the table.

The Demand Curve Facing the Firm


1

Price

per Bed

Number of Bed

Frames per Day1 2 3 4 65 7 8 9

200

10

450

$600

Demand Curve Facing Ned’s

Beds

The Firm’s Constraints• Total revenue, TR

– The total inflow of receipts from selling a given amount of output

• Demand and total revenue– Each time the firm chooses a level of

output, it also determines its total revenue


The Firm’s Constraints• Total Revenue and Elasticity

– Lower price: sell more output• If ED > 1 (elastic demand): total revenue will

rise• If ED < 1 (inelastic demand): total revenue will

fall

• The cost constraint (minimizing costs)– Given production technology– Firm must pay prices for each of the inputs

that it uses


The Profit-Maximizing Output Level• Total revenue and total cost approach

– Profit is the difference between TC and TR at each output level

– The firm chooses the output level where profit is greatest

• Loss – Difference between total cost (TC) and

total revenue (TR)– When TC > TR


The Profit-Maximizing Output Level• Marginal revenue (MR = ΔTR / ΔQ)

– Change in total revenue from producing one more unit of output

– Change in the firm’s total revenue (TR) divided by the change in its output (Q)

– Tells us how much revenue rises per unit increase in output


The Profit-Maximizing Output Level• When MR is positive

– An increase in output causes total revenue to rise

• When MR is negative– An increase in output causes total revenue

to fall• As output increases

– MR is smaller than the price


TableMore Data for Ned’s Beds


1

The Profit-Maximizing Output Level• Downward-sloping demand curve

– Each increase in output causes• A revenue gain: from selling additional output

at the new price• A revenue loss: from having to lower the price

on all previous units of output

– Marginal revenue is less than the price of the last unit of output


The Profit-Maximizing Output Level• An increase in output

– Will always raise profit as long as MR>MC– Will always lower profit whenever MR<MC

• Marginal revenue and marginal cost approach– Profit-maximizing output level– Increase output whenever MR>MC– Decrease output when MR< MC


The Profit-Maximizing Output Level• Marginal revenue for any change in output

– Is equal to the slope of the total revenue curve along that interval

• TC and TR approach using graphs– Maximize profit– Produce the quantity of output where the

vertical distance between the TR and TC curves is greatest

– And the TR curve lies above the TC curve


The Profit-Maximizing Output Level• MC and MR approach using graphs

– Maximize profit– Produce the quantity of output closest to

the point where MC = MR• MC and MR curves intersect• MC curve crosses the MR curve from below


Figure

Panel (a) shows the firm’s total revenue (TR) and total cost (TC) curves. Profit is the vertical distance between the two curves at any level of output. Profit is maximized when that vertical distance is greatest—at 5 units of output.

Profit Maximization (a)


2

Dollars

Output 1 2 3 4 65 7 8 9

500

10

1,000

$3,500

1,500

2,000

2,500

3,000TC

TR

Profit at

7 units

Profit at

3 units

ΔTR from producing 1st unit

Profit at

5 units

ΔTR from producing 2nd unit

Total Fixed Cost

Figure

Panel (b) shows the firm’s marginal revenue (MR) and marginal cost (MC) curves. Profit is maximized at the level of output closest to where the MR and MC curves cross—at 5 units of output.

Profit Maximization (b)


2

Dollars

Output 1 2 3 4 65 7 8 9

400

10

0

100

200

300

500

600

$700

-100

-200

MR

MC

Profit rises Profit falls

The Profit-Maximizing Output Level• A Proviso

– Sometimes the MC and MR curves cross at two different points

– The profit-maximizing output level is the one at which the MC curve crosses the MR curve from below


Figure

Sometimes the MR and MC curves intersect twice. The profit-maximizing level of output is always found where MC crosses MR from below.

Two Points of Intersection


3

Dollars

Output Q1 Q*

MR

MC

B

A

The Profit-Maximizing Output Level• Average costs

– Irrelevant to profit maximizing decisions • Marginal approach to profit

– A firm maximizes its profit by taking any action that adds more to its revenue than to its cost: MR > MC


Dealing with Losses• Shutdown rule in the short run

– The firm should continue to produce if TR > TVC (otherwise, it should shut down)

– Let Q* be the output level at which MR=MC• If TR > TVC at Q*, the firm should keep

producing• If TR < TVC at Q*, the firm should shut down• If TR = TVC at Q*, the firm should be

indifferent between shutting down and producing


Figure

The firm shown here cannot earn a positive profit at any level of output. If it produces anything, it will minimize its loss by producing where the vertical distance between TR and TC is smallest. Because TR exceeds TVC at Q*, the firm will produce there in the short run.

Loss Minimization


4

Dollars

Output Q*

TC

TRTFC

TFC

TVCLoss at Q*

Dollars

Output Q*

MC

MR

Figure

At Q*, this firm’s total variable cost exceeds its total revenue. The best policy is to shut down, produce nothing, and suffer a loss equal to TFC in the short run.

Shut Down


5

Dollars

Output Q*

TR

TFC

TFC

TVCLoss at Q*

TC

Dealing with Losses• Exit

– A permanent cessation of production when a firm leaves an industry

• In the long run– A firm should exit the industry when—at its

best possible output level—it has any loss at all


Getting It Wrong: The Failure of Franklin National Bank

• Mid-1974s, Franklin National Bank’s manager– Average cost of $1 in loans = 7 cents– Offered loans at 8% interest (MR)– Borrowed in federal funds market at 9-11%

interest (MC)


Getting It Right: Continental Airlines

• 1960’s, all other airlines– Offer a flight only if, on average, 65% of

the seats could be filled with paying passengers

– ATC = $4,000 per flight


Getting It Right: Continental Airlines

• Continental Airlines– Flying jets filled to just 50% of capacity– Expanding flights on many routes– Higher profits– MC = $2,000 per flight


chapter 8

Economy & Finance

classroom use

cengage learning

passwordprotected website

certain product

goal of profit maximization

implicit profit payment

profit maximization

owners profit decisions